CHALLENGES FOR THE 2004 SPENDING REVIEW Robert Chote Carl Emmerson Christine Frayne Sarah Love THE INSTITUTE FOR FISCAL STUDIES Briefing Note No. 50 Challenges for the 2004 Spending Review Robert Chote, Carl Emmerson, Chris Frayne and Sarah Love* Institute for Fiscal Studies July 2004 Introduction to Spending Reviews in the UK The present government’s aims include achieving ‘world-class public services’,1 eliminating child2 and pensioner3 poverty, and increasing the proportion of young people participating in higher education.4 Achieving these aims is likely to require continued increases in the level of funding for public services. This Briefing Note considers the options for public spending during the years of the forthcoming Spending Review 2004 (2005–06 to 2007–08), in light of what has already been announced and what we know about the government’s priorities and past spending decisions. Since the July 1998 Comprehensive Spending Review (CSR), spending limits for government departments have been set every two years in Spending Reviews, with the most recent one occurring in July 2002. This revised the existing plans for 2003–04 and set out plans for 2004–05 and 2005–06. The next Spending Review will be on 12 July 2004. It should confirm the plans for 2005–06 that were set out in the July 2002 Spending Review and revised in the April 2004 Budget, and set out departments’ allocations for a further two years – 2006–07 and 2007–08. Table 1 shows which years are covered by each Spending Review (SR) since July 1998. Table 1. The years covered by the Spending Reviews * Financial support from the ESRC-funded Centre for the Microeconomic Analysis of Public Policy at IFS (grant number M535255111) is gratefully acknowledged. Any errors and all opinions expressed are those of the authors. 1 See section 2, ‘World-class public services: how investment and reform will improve public services’, in Labour Party, Ambitions for Britain (Labour’s 2001 general election manifesto), London, 2001 (http://www.labour.org.uk/ENG1.pdf). 2 Source: Tony Blair, Beveridge Speech, 18 March 1999, Toynbee Hall. 3 Source: Gordon Brown, Labour Party conference, 30 September 2002. 4 See, for example, http://www.dfes.gov.uk/hegateway/strategy/hestrategy/expand.shtml. 1 1999–2000 2000–01 2001–02 2002–03 2003–04 Comprehensive Spending Review July 1998 Spending Review July 2000 2004–05 2005–06 2006–07 2007–08 Spending Review July 2002 Spending Review July 2004 The 2004 Budget has already set for 2006–07 and 2007–08 the overall spending amounts, the division between current and capital spending, and the amounts to be received by the Department for Education and Skills. In addition, the allocation for the National Health Service (NHS) until 2007–08 was set out in the April 2002 Budget. The remaining issues for Spending Review 2004 to decide are: (i) the division of total spending between departmental and non-departmental spending and (ii) the distribution of the departmental spending between the other departments once the NHS and education allocations have been taken into account. According to Budget 2004, total public spending (known as total managed expenditure, or TME) will rise from £488 billion in 2004–05 to £579 billion in 2007–08. If delivered, this would lift TME from 41.6% of national income in 2004–05, the present financial year, to 42.3% by 2007–08. This would be the highest level of public spending relative to national income since the present Labour government came to power. It would also take the average level of public spending under Labour from its current 39.0% of national income to 40.1%. However, this would still be well below the average of 44.0% for the Conservative years of 1979–80 to 1996–97. The UK’s public sector would remain in line with the current OECD average but smaller than that of many European countries. Figure 1 shows the annual real increases in TME from when Labour came into government in 1997–98 until the plans for 2007–08. The graph shows that planned increases in TME from 2004–05 to 2007–08 represent an average real rate of spending growth of 3.1% a year. This increase will not be spread evenly over the three years: real growth is planned to be 4.1% in 2005–06, 2.5% in 2006–07 and 2.8% in 2007–08. In the first two years of the present government, there was no growth in spending: 1997–98 and 1998–99 saw a combination of historically low spending plans (which were set out by the Conservatives and retained by Labour) and reduced cyclical spending (such as expenditure on social security benefits) thanks to a strong economy. Since then, public spending growth has increased. The planned real growth of 3.3% in 1999–2000, the first year of the Comprehensive Spending Review, did not materialise in full, due to both underspending by departments and lower debt interest payments and cyclical spending as strong economic growth continued. But the later years of the CSR and the whole of the Spending Review 2000 period saw substantial public spending growth. The average real-terms annual increases over the CSR and 2 SR 2000 periods were 3.4% and 4.7% respectively. The figure for SR 2002 is expected to be higher still, at 4.9% for the three years to 2005–06. Therefore, as Figure 1 illustrates, although public spending is planned to continue growing faster, on average, than national income during the three years covered by SR 2004, the 3.1% real annual rate of increase will be considerably slower than that of recent Spending Reviews. This will bring the average real annual increase in public spending during the SR 2004 period in line with the present Labour government’s overall average since coming to office in 1997. Moreover, the largest increase will take place in the first year of the SR 2004 period, namely 2005–06, for which allocations across departments have already been determined. The choices that remain for SR 2004 relate to the two following years, during which average real growth in TME is expected to be just 2.7%. Percentage increase Figure 1. Real increases in total managed expenditure 7 6 5 4 3 2 1 0 -1 -2 Eleven-year average SR 2000 outturns SR 2004 plans CSR outturns SR 2002 outturns and plans 97-98 98-99 99-00 00-01 01-02 02-03 03-04 04-05 05-06 06-07 07-08 Sources: HM Treasury, Budget 2004, HC 301, London, March 2004 (http://www.hmtreasury.gov.uk/budget/budget_04/budget_report/bud_bud04_repindex.cfm) and Public Finances Databank 27 May 2004, London, 2004 (http://www.hmtreasury.gov.uk/Economic_Data_and_Tools/data_index.cfm); Office for National Statistics website (http://www.statistics.gov.uk). It is worth noting that the actual spending outturns in recent years have generally exceeded the initially planned amounts in previous Spending Reviews, as the Chancellor has added to the initial plans over the years. Spending Review 2002, for example, planned for TME to reach £511 billion by 2005–06, which would have meant average annual real spending growth of 4.3% over the three years of the Spending Review – lower than the 4.9% that is currently envisaged under plans that include higher spending on items such as the child tax credit and the new Child Trust Fund. Similarly, the outturns for the years of Spending Review 2000 were higher than initially set out, resulting in average real growth of 4.7% a year instead of the 2.8% implied by the 3 spending plans. It is therefore possible that the amounts currently pencilled in for 2005–06 to 2007–08 will not be the final sums, even if these numbers are confirmed in the Spending Review. But it is unlikely that there will be the same room for upward revisions to spending as there was during previous Spending Reviews, given the tight margin with which the Chancellor is now forecasting to meet his fiscal rules going forward. Planning public spending: departmental expenditure limits and annually managed expenditure Just over half of government spending falls within departmental expenditure limits (DELs), which are allocated across departments in Spending Reviews. The remainder is classified as annually managed expenditure (AME), and is planned on an annual basis. The division of TME into DELs and AME will therefore determine the proportion of total public spending that can be allocated to departments. The rest, in AME, is used to fund functions that are more difficult to plan in advance, such as social security payments and spending by devolved governments. The AME/DELs split for 2005–06 was decided in Spending Review 2002, and has been revised in subsequent Budgets and Pre-Budget Reports (PBRs). According to Budget 2004, overall spending for that year is expected to stand at £520.4 billion, with £219.2 billion falling in AME and £301.1 billion in DELs – although the AME figure is a forecast based on the expected performance of the economy. Overall spending is set to be £548 billion in 2006–07 and £579 billion in 2007–08, but the split between AME and DELs – and therefore the exact amount to be allocated between departments – has not yet been announced. The next section of this Briefing Note will discuss the likely contents of Spending Review 2004 in more detail, and will consider what the split between AME and DELs in 2006–07 and 2007–08 might be. Spending Review 2004 in detail Table 2 summarises the information that we already have about public spending during the Spending Review 2004 period. As was outlined above, overall TME is planned to increase from £520.4 billion in 2005–06 to £579 billion in 2007–08. Within these totals, the amounts to go to the NHS and education – two of the largest public spending functions – have already been allocated. Between them, these two public services consume over a quarter of total public spending, so the generosity of their allocations has a significant effect on the amount left over for other public services. The NHS, which will receive about £82 billion this year, is expected to receive £109 billion in 2007–08 – corresponding to a 7.1% real-terms average annual increase. Spending on education is planned to increase from £63 billion in 2004–05 to £77 billion by 2007–08 – an average annual real increase of 3.9%. 4 Table 2. Government spending going forward (£ billion) To be reviewed/decided in July 2004? AME spending DELs spending TME of which: Current spendinga Capital spending NHS spending Education spending TME excluding NHS & education 2004–05 No 208.3 279.3 487.6 2005–06 Yes, but likely to be confirmed 219.2 301.1 520.4 2006–07 Yes – within overall TME total Not known Not known 548 2007–08 Yes – within overall TME total Not known Not known 579 465.2 22.4 82.2 63.2 342.2 495.2 25.2 90.5 68.1 361.8 521 27 99.4 72.3 376.4 548 31 109.4 76.6 393.0 Sources: HM Treasury, Public Expenditure Statistical Analyses 2004, Cm. 6201, London, April 2004 (http://www.hm-treasury.gov.uk/media//FC4B2/pesa04_complete_190404.pdf) and Budget 2004. a Current spending includes depreciation. How much money is left to share out? What will be left once the NHS and education have received their Spending Review 2004 allocations? Between them, the two ‘pre-allocated’ functions are planned to grow by a real annual average of 5.7% a year over the three years of the 2004 Spending Review, leaving an increase of only 2.0% a year of average real growth in other spending. However, as funds have already been fully allocated for the first of these three years (2005–06), the real choices relate to the allocations for the last two years. Over 2006–07 and 2007–08, the combined NHS and education plans are for an average annual real increase of 5.4%, leaving an increase of just 1.4% for other areas. In comparison, the Spending Review 2002 years are set to deliver increases of 4.2% per year for these remaining areas. Budget 2004 also contained several less specific commitments about spending allocations for other functions. In addition to the money set aside for health and education, the Chancellor has stated he will increase spending on defence, the Home Office, transport and international development in real terms, and that he will increase spending on housing, local government, children and the elderly in nominal terms.5 As well as being split into different functions and allocated to DELs or AME, public spending can also be divided into current and capital components. Current spending covers expenditure on all non-durable items, such as wages and debt interest. Capital spending, by contrast, describes purchases of lasting assets, such as buildings and machinery. According to Budget 2004, ‘the 5 Chancellor of the Exchequer’s Budget Statement, 17 March 2004 (http://www.hmtreasury.gov.uk/budget/budget_04/bud_bud04_speech.cfm). 5 capital expenditure of the 2004 Spending Review envelope is based on public sector net investment increasing from 2 per cent of GDP in 2005–06 to 2¼ per cent of GDP by 2007–08’.6 This entails an average annual real increase in public sector net investment (PSNI) of 8.5% a year over the three years of Spending Review 2004, or 7.9% for the last two. This leaves room for public sector current spending to grow by an average of only 2.9% in real terms over three years, or 2.4% over the last two – which would only just match the expected growth rate of the economy. The planned rate of growth in capital spending is high, but it is significantly lower than the 30.2% average annual real growth in PSNI that the Treasury expects to achieve over the Spending Review 2002 period. Of course, despite capital spending coming in lower than planned in recent years, the lower growth rate in the future will be applied to a significantly higher stock of existing capital spending than when the Spending Review 2002 plans were being drawn up. PSNI is planned to increase from 0.9% of national income in 2002–03 to 2.0% by the end of the Spending Review 2002 period, and then to continue increasing to 2.3% by 2007–08. Table 3. Average percentage increases in components of public spending Spending Review 2002 From April 2004 Budget announcements Total government spending of which: Current spending Capital spending NHS spending Education spending Government spending excluding NHS & education 2003–04, 2004–05 & 2005–06 Spending Review 2004 3 years 2005–06, 2006–07 & 2007–08 Spending Review 2004 Last 2 years 2006–07 & 2007–08 4.9 3.1 2.7 4.1 33.7 7.3 5.5 4.2 2.9 8.5 7.1 3.9 2.0 2.4 7.9 7.0 3.3 1.4 Sources: HM Treasury, Public Expenditure Statistical Analyses 2004 and Budget 2004. Table 3 summarises what the figures contained in Table 2 imply for growth rates in the different components of public spending. It shows the extent to which almost all spending functions, even those set to receive relatively generous amounts of public money, will experience progressively tighter growth rates over the course of the next few years, which are particularly marked in comparison with the years of the previous Spending Review. In particular, the later years of the Spending Review 2004 period – 2006–07 and 6 HM Treasury, Budget 2004, HC 301, London, March 2004, paragraph C26, page 249 (http://www.hm-treasury.gov.uk/budget/budget_04/bud_bud04_index.cfm). 6 2007–08 – will see total current spending only growing at the same rate as the whole economy. What are we likely to see in Spending Review 2004? Having reviewed the decisions that the Chancellor has already taken and considered their implications, we now turn to the possible split of TME between AME and DELs. Budget 2003 stated that prior to spending plans being set in the next Spending Review, assumed real growth in DEL after 2005–06 is in line with the economic growth assumption used for the public finances, supplemented by an addition to allow for the five-year health settlement of the difference between planned health growth and health’s long-term average growth of 3.6 per cent.7 It is expected that DELs in 2005–06 will sum to £301.1 billion, of which the NHS in England will account for £76.1 billion. This is lower than the £90.5 billion that will be spent on the NHS in the UK as a whole, as spending outside England is not contained in the Department of Health DEL and a small proportion of NHS spending is in AME. Table 4. AME and DELs in the Spending Review 2004 years, according to the assumptions in the 2003 Budget and Pre-Budget Report (£ billion) AME spending DELs spending TME of which: NHS spending Non-NHS spending 2004–05 208.3 279.3 487.6 2005–06 219.2 301.1 520.4 2006–07 228.3 319.7 548 2007–08 240.1 338.9 579 82.2 405.4 90.5 429.9 99.4 448.6 109.4 469.6 Sources: HM Treasury, Budget 2003, HC 500, London, April 2003 (http://www.hmtreasury.gov.uk/Budget/bud_bud03/bud_bud03_index.cfm), Public Expenditure Statistical Analyses 2004, Budget 2004 and Public Finances Databank 27 May 2004. If we assume that the NHS DEL grows at the same rate as overall UK NHS spending between 2005–06 and 2007–08, then we can estimate what will happen to the NHS DEL during the Spending Review 2004 period and estimate what would happen, on the assumptions of Budget 2003, to overall DELs during the Spending Review 2004 years. As we know the overall level of spending, we can also estimate how much money will be left for AME. The results are shown in Table 4. On the 2003 Budget assumptions, AME would increase by about £20 billion over the last two Spending Review 2004 years, while DELs would increase by about £40 billion. This would represent average 7 HM Treasury, Budget 2003, HC 500, London, April 2003, paragraph C24, page 249 (http://www.hm-treasury.gov.uk/Budget/bud_bud03/bud_bud03_index.cfm). 7 annual real-terms increases of 1.9% and 3.3% respectively. By contrast, the average real increases for the 2002 Spending Review period are now planned to be 4.5% a year for AME and 5.2% for DELs. What are the implications of the AME/DELs split in Table 4 for spending on other functions? It was noted above that the planned increases in spending on the NHS and education will, if delivered, leave average real growth of only 1.4% a year in spending on other functions for 2006–07 and 2007–08. Of the remaining spending functions, the largest ones are social security (which mainly comprises transfer payments), law & order, defence and transport. Spending in AME Over the three years covered by Spending Review 2002, spending on social security benefits and tax credits is expected to rise by an average of 3.3% per year in real terms. All spending on these items is contained in AME. Given the government’s commitment to eliminate child and pensioner poverty, it is likely that spending on these items will continue to grow. If it were to continue to grow at the same rate for the two years after 2005–06 as in Spending Review 2002, then spending on other functions in AME would have to be cut in real terms by an average of 0.9% per year for 2006–07 and 2007–08, if the AME/DELs allocations set out in Table 4 were to be realised. Other items in AME include local governments’ self-financed expenditure and debt interest payments. Spending in DELs With respect to DELs, Budget 2004 specified that the DEL of the Department for Education and Skills (DfES) would rise by an average of 3.4% a year in real terms in 2006–07 and 2007–08. Budget 2002 said that total NHS spending would grow by 7.0% a year in real terms over the same period. If we assume that the elements of NHS spending that fall within DEL grow at the same rate, this would leave scope for other departments’ DELs to grow by an average of 1.7% a year in real terms in 2006–07 and 2007–08 if the split between AME and DELs follows the assumptions in last year’s Budget. This is lower than the 3.8% a year increase over the three years of Spending Review 2002. According to Public Expenditure Statistical Analyses 2004, departmental spending on the NHS and DfES together will account for 35.6% of total DELs in 2005–06. Aside from departments dealing with local government in England and spending in Scotland, Wales and Northern Ireland (which cover a variety of functions, including education and health), the next largest components of DELs that fund specific services will be defence (10.2%), the Home Office (4.6%) and transport (3.7%). Over the period covered by Spending Review 2002, the latest figures show that the defence budget is now expected to shrink by 0.8% a year in real terms, creating room for bigger increases in other departments within the overall 8 spending envelope (including increases of 5.1% a year for transport and 3.7% a year for the Home Office). But in Budget 2004, the Chancellor promised that the defence budget would be increased in real terms during the Spending Review 2004 period (although he did not specify whether the increase would take place over all three years from 2005–06 to 2007–08 or just during the last two). This will intensify the squeeze on other departments in 2006–07 and 2007–08 that is already implied by the slower growth in DELs overall. Real increases in the defence budget would imply that DELs outside defence, the DfES and the NHS could rise by no more than 2.0% a year in 2006–07 and 2007–08, compared with 3.0% in Spending Review 2002. If DEL increases for transport and the Home Office were then maintained at the rates planned over Spending Review 2002, spending in the departments covering the remaining 45.9% of DELs could only rise by 1.6% a year. Table 5. Possibilities for growth in DELs in 2006–07 and 2007–08 Department NHS (England) Education (England) Defence Local Government Scotland Home Office Wales Transport Northern Ireland Executive Office of Deputy PM Trade & Industry Chancellor’s departments International development DEFRA Culture, Media & Sport FCO All others DEL in 2005–06 (£ billion) 76.1 31.1 30.8 46.2 22.8 13.8 11.9 11.3 7.5 7.5 5.4 5.2 4.5 3.3 1.5 1.5 20.5 % of total DELs in 2005–06 25.3 10.3 10.2 15.3 7.6 4.6 4.0 3.7 2.5 2.5 1.8 1.7 1.5 1.1 0.5 0.5 6.8 Real annual % DEL growth in: Spending 2006–07 & Review 2002 2007–08a 8.3 7.0 6.5 3.4 –0.8 0.0 4.5 ⎫ 5.5 ⎪ 3.7 ⎪ 5.1 ⎪ ⎪ 5.1 ⎪ 0.2 ⎪⎪ 9.0 2.1 ⎬ 6.1 ⎪ 3.9 ⎪ 5.3 ⎪ 8.3 ⎪ 5.8 ⎪ –2.1 ⎪ 5.3 ⎪⎭ a Based on the following assumptions: (i) DfES DEL follows the plans from Budget 2004; (ii) NHS DEL increases at the same rate as the planned UK NHS spending increases in Budget 2002; and (iii) defence DEL remains constant in real terms in 2006–07 and 2007–08. Notes: Figures may not sum exactly due to rounding. DEFRA = Department for the Environment, Food & Rural Affairs; FCO = Foreign & Commonwealth Office. Sources: HM Treasury, Public Expenditure Statistical Analyses 2004 and Public Finances Databank 27 May 2004. Among the smaller departments, it also seems plausible to assume that the Department for International Development (1.5% of last year’s total DELs) will receive a relatively generous settlement, as the government has promised to raise the overseas aid budget from the 0.4% of national income planned for 2005–06 to the United Nations’ target of 0.7% (but without giving a timescale). 9 This suggests that spending on overseas aid will rise by more than 2.5% a year in real terms, to increase overseas aid as a share of national income. Table 5 summarises the implications of the possibilities discussed above. The table shows that even if the Chancellor gives the NHS, education and defence nothing more than they have already been promised, he will already be squeezing other departments by allowing their DELs to increase by just 2.1%, which is lower than the growth in national income. If the defence budget increases in real terms and transport, the Home Office and international development receive DEL increases in 2006–07 and 2007–08 that are similar to their Spending Review 2002 averages, then the remaining functions (including trade & industry, culture, media & sport, and environment, food & rural affairs) will face two years of minimal budgetary growth. Targets and efficiency So what is the implication of lower growth in public spending for the two last years of Spending Review 2004 in terms of the quality of public services? The Chancellor believes that significant improvements can be made through better use of public spending. The 2004 Budget announced that there is to be a nominal freeze on all administration spending beyond 2005–06. This is to be achieved by a large reduction in staff in areas such as the Department for Work and Pensions and the Inland Revenue. In total, the freeze on administrational spending will save at least £1.1 billion in 2007–08, but it remains to be seen whether it can be delivered without any detrimental effect on service delivery. In addition to these administrational savings, the Chancellor has set a target to improve public service efficiency by 2½% a year from April 2005 to March 2008. If achieved, this is equivalent to a saving of around £20 billion per year – a far more substantial sum than the expected savings from reductions in administrative costs. The Chancellor has argued that this can be done using the findings of the Gershon Review of public service delivery. This Review has apparently identified a number of means by which efficiency gains can be made, including increased sharing of purchasing arrangements, streamlined back-office operations and reduced transaction costs. Due to the difficulties in measuring the outputs of the public sector, it will be very hard to estimate whether or not this is actually achieved. It is worth noting that the 2½% a year target for improved public service efficiency is higher than the Treasury’s forecast of 2¼% a year growth in economy-wide productivity. This, and the fact that Michael Portillo’s 1994 Fundamental Expenditure Review and Gordon Brown’s 1998 Comprehensive Spending Review have both already sought to deliver improvements in efficiency, highlight that achieving this target is unlikely to be easy. So there remains the open question of whether any of these savings is actually deliverable. If they prove elusive, then it seems probable that, in some areas, public services will fall short of the Chancellor’s aspiration of being ‘world 10 class’. Under this scenario more resources, with an associated cost in terms of higher cost to the public, would need to be found if further improvements were to be made. Appendix A. Historical series of government spending Table A.1. Public spending as a percentage of GDP 1970–71 1971–72 1972–73 1973–74 1974–75 1975–76 1976–77 1977–78 1978–79 1979–80 1980–81 1981–82 1982–83 1983–84 1984–85 1985–86 1986–87 1987–88 1988–89 1989–90 1990–91 1991–92 1992–93 1993–94 1994–95 1995–96 1996–97 1997–98 1998–99 1999–2000 2000–01 2001–02 2002–03 2003–04 HM Treasury forecasts 2004–05 2005–06 2006–07 2007–08 Current spendinga Net investment 36.6 37.3 36.8 39.2 43.2 44.4 44.5 42.9 42.8 42.7 45.4 47.3 47.0 46.5 46.5 44.4 43.3 41.4 38.9 38.5 38.4 40.6 42.1 42.0 41.7 41.1 40.0 38.6 37.5 37.0 37.7 37.9 38.7 39.8 6.0 5.3 4.8 5.2 5.5 5.5 4.3 2.8 2.4 2.2 1.8 0.9 1.5 1.8 1.5 1.2 0.7 0.6 0.4 1.2 1.4 1.9 2.0 1.6 1.5 1.4 0.8 0.7 0.7 0.4 0.5 0.9 0.9 1.5 Total managed expenditure 42.7 42.6 41.7 44.4 48.8 49.9 48.8 45.8 45.2 44.9 47.2 48.2 48.5 48.3 48.0 45.6 44.0 42.1 39.3 39.7 39.8 42.4 44.1 43.6 43.2 42.6 40.7 39.3 38.2 37.4 38.2 38.9 39.6 41.2 39.7 40.0 40.0 40.0 1.9 2.0 2.1 2.3 41.6 42.1 42.0 42.3 a Including depreciation. Source: HM Treasury, Public Finances Databank 27 May 2004. 11